Where is the Work in Working Capital?

A producer from Ohio really challenged a young lender the other day. He stated, “You lenders and academics preach that I need working capital reserves. However, I cannot see how working capital really works for me.”

Let’s examine the producer’s comments and provide some insight. First, working capital is derived by subtracting current liabilities (or obligations due within a year) from current assets (which can be turned to cash in one year or less). The remaining amount, either positive or negative, is net working capital.

Working Capital = Current Assets – Current Liabilities

There are certain myths concerning working capital. The first myth is that working capital consists only of cash. Let us dispel that myth. Working capital includes assets that can be turned to cash within one year minus financial obligations due within the next 12 months. Items such as inventory, receivables, prepaid expenses, crops growing in the field, and, yes, cash make up the assets that generate working capital.

Where is the work in working capital reserves? These assets, including cash, are available to cover obligations that result from a downturn in the economic cycle, a management failure, or when a financial obligation arises unexpectedly. Working capital works for many business owners in periods of extreme revenue and cost volatility and bridges the gaps for business sustainability.

Another angle on the work in working capital is that working capital reserves can be utilized to capitalize on opportunities. In periods of economic and financial adversity, capital assets frequently can be purchased at a steep discount. Working capital reserves can provide the flexibility to take advantage of the cash discounts or buying opportunities that can reduce the cost of production and actually increase margin.

A management principle one must consider is that working capital is often not about short run maximization of return. Working capital reserves focus on return of assets on a timely basis to navigate the business white waters or adversity, or take advantage of opportunities.

Much of business success is about planning, and working capital is a major component of planning. Often planning meshed with timing equates to overall business success in the long run.

P.S. Many producers, like the producer from Ohio, are growing leery of their lender’s suggestions to increase working capital. The great commodity super cycle has created prosperity, which sometimes leads to complacency in management.